COST ANALYSIS

What is cost?
• In producing a commodity a firm has to
employ an aggregate of various factors of
production such as land, labour, capital and
entrepreneurship.
• These factors are to be compensated by the
firm for their contribution in producing the
commodity.
• This compensation (factor price) is the cost.
 Various concepts of Cost

• 1. Real Cost
• 2. Opportunity or Alternative Cost
• 3. Money Cost – Explicit & Implicit Costs
• 4. Accounting & Economic Costs
• 5. Fixed and Variable Costs
 Cost concepts
• 6. Production Costs –
• Total Cost (TC)
• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
• Average Fixed Cost (AFC)
• Average Variable Cost (AVC)
• Average Total Cost (ATC) and
• Marginal Cost (MC)
 Real Cost
• The ‘real cost of production’ refers to the
physical quantities of various factors used
in producing a commodity.
• Real cost signifies the aggregate of real
productive resources absorbed in the
production of a commodity (or a service).
 Opportunity Cost
• The concept of opportunity cost is based on the
scarcity and alternative applicability
characteristics of productive resources.
• The real cost of production of something using
a given resource if the benefit forgone (or
opportunity lost) of some other thing by not
using that resource in its best alternative use.
• An opportunity cost or alternative cost is the
value of a resource in a foregone employment.
 Economists’ Money Costs
• Economists wish to include imputed value of all
the inputs provided by the producer himself in
addition to outright money transactions between
the firm and other parties from whom inputs are
purchased for carrying out production.
• Thus money costs in economic terms or
• Economic cost = explicit or Accounting costs +
implicit costs.
 Sunk Costs

• Sunk cost is a cost once incurred cannot be

retrieved. It is associated with commitment
of funds to specialized equipment or
facilities which cannot be used for anything
else in the present or future. E.g.brewery
plant during prohibition.
 Shutdown Costs
• Shut down costs are costs which would be
incurred when plan operation is suspended, but
would have been saved if the operation was
continuing.
• E.g. costs of sheltering plant and equipment.
• Construction or hiring of sheds for storing
exposed property.
• Expenses on recruitment and training incurred on
re-employment of workers.
 Abandonment Costs
• Abandonment arises when there is complete
cessation of activities and there is a problem
of disposal of assets.

• E.g.discontinuance of using typewriters and

shifting over usage to computers.
• Shifting to paperless operations.
 Replacement and Historical
Costs
• Historical cost means the cost of a plant at a
price originally paid for it. Replacement
cost means the price that would have to be
paid currently for acquiring the same plant.
 Economic Cost
• Explicit costs are direct contractual monetary
payments incurred through market
transactions.
• Explicit costs are usually costs shown in the
accounting statements and include costs of raw
materials, wages and salaries, power and fuel,
rent, interest payments of capital invested,
Insurance, Taxes and duties, Misc. expenses such
as selling, transport, advertising & sales
promotional expenses.
 Economic Cost (contd.)
• Implicit costs are the opportunity costs of the
use of factors which a firm does not buy or hire
but already owns.
• Implicit costs include
• Wages of labour rendered by the entrepreneur himself.
• Interest on capital supplied by him.
• Rent of land and premises owned by the entrepreneur and used
for production.
• Normal returns or profits of entrepreneur as compensation for
his management and organizational services.
 Fixed Costs
• Fixed costs are those costs that are
incurred as a result of the use of
fixed factor inputs. They remain
fixed at any level of output.
• While engaging in productive
activity the producer always has to
incur some expenditure which
remains fixed whatever the level of
production.
 Fixed Costs
• In the short run, fixed costs remain fixed
because the firm does not change its size and
the amount of fixed factors employed which
include:
• Payments of rent for building.
• Interest on capital.
• Insurance premium
• Depreciation and Maintenance allowances
• Adm. Expenses (Managerial & Staff salaries)
• Property and business taxes, licence fees etc.
 Variable Costs
• Variable costs are those costs that are
incurred by the firm as a result of the
use of variable factor inputs. They are
dependant on the level of output.
• The cost which keeps on changing with
the changes in the quantity of output
produced is known as variable cost.
 Variable costs
• The short-run variable costs include
• Prices of raw materials,
• Wages paid for labour
• Fuel and power
• Excise duties, sales tax, octroi, VAT.
• Freight (or transportation) charges..
 Production Costs

• Total Cost (TC)

• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
• Average Fixed Cost (AFC)
• Average Variable Cost (AVC)
• Average Total Cost (ATC) and
• Marginal Cost (MC)
 Theory of Cost in the Short run
•Total Cost TC = TFC + TVC
•Average Fixed Cost AFC = TFC  Q
•Average Variable Cost AVC = TVC  Q
•Average Total Cost ATC = TC  Q
= TFC/Q + TVC/Q
Marginal Cost
MC = CRVC
QQ
 Short-run Production costs
Figures in rupees
Output Total Total Total Cost
(Units) Fixed Cost Variable Cost
0 240 0 240
1 240 120 360
2 240 160 400
3 240 180 420
4 240 212 452
6 240 280 520
 Cost curves
ATC
MC

AVC
COST

AFC

OUTPUT
 Average Fixed Cost, Average Variable Cost and
Average Total cost of the Firm
Output Average Average Average
(Units) Fixed Cost Variable Cost Total Cost
TFC Q TVC Q TC Q
1 240 1 = 240 120 1 = 120 360 1 = 360
2 240 2 = 120 160 2 = 80 400 2 = 200
3 240 3 = 80 180 3 = 60 420 3 = 140
4 240 4 = 60 212 4 = 53 452 4 = 113
5 240 5 = 48 280 5 = 56 520 5 = 104
6 240 6 = 40 420 6 = 70 660 6 = 110
 Calculation of Marginal Cost
Output Total Cost Total Variable Marginal Cost
(units) (Rupees) Cost(Rupees) (Rupees)
0 240 0 --
1 360 120 120
2 400 160 40
3 420 180 20
4 452 212 32
5 520 280 68
6 660 420 140
Output TFC TVC TC AFC AVC ATC MC
(units) (TFC/Q) (TVC/Q) (TC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 100 0 100 -- -- -- --
1 100 25 125 100 25 125 25 (125-100)

2 100 40 140 50 20 70 15(140-125)

3 100 50 150 33.3 16.6 50 10 (150-140)

4 100 60 160 25 15 40 10(160-150)

5 100 80 180 20 16 36 22(180-160)

6 100 110 210 16.3 18.3 35 30(210-180)

7 100 150 250 14.2 21.4 35.7 40(250-210)

8 100 300 400 12.5 37.5 50 150(400-250)

9 100 500 600 11.1 55.6 66.7 200(600-400)

Output TFC TVC TC AFC AVC ATC MC
(units) (TFC/Q) (TVC/Q) (TC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 100 0 100 -- -- -- --
1 100 25 125 100 25 125 25 (125-100)

2 100 40 140 50 20 70 15(140-125)

3 100 50 150 33.3 16.6 50 10 (150-140)

4 100 60 160 25 15 40 10(160-150)

5 100 80 180 20 16 36 22(180-160)

6 100 110 210 16.3 18.3 35 30(210-180)

7 100 150 250 14.2 21.4 35.7 40(250-210)

8 100 300 400 12.5 37.5 50 150(400-250)

9 100 500 600 11.1 55.6 66.7 200(600-400)

Problem: Based on your knowledge of the various measures of
short run cost, complete the following table.

Output TFC TVC TC AFC AVC ATC MC

(units) (TFC/Q) (TVC/Q) (TC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 --- --- 1200 X X X X
1 --- --- 1265
2 --- 204
3 --- --- 494
4 --- --- 86
5 --- 525
6 --- --- 286
7 --- --- 97
8 --- 768
9 --- --- 97
Problem: Based on your knowledge of the various measures of
short run cost, complete the following table.

Output TFC TVC TC AFC AVC ATC MC

(units) (TFC/Q) (TVC/Q) (TC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 1200 0 1200 X X X X
1 1200 265 1265 1200 265 1265 265
2 1200 204 1404 600 102 702 139
3 1200 283 1483 400 94 494 79
4 1200 369 1569 300 92 392 86
5 1200 525 1725 240 105 345 156
6 1200 580 1780 200 96 286 65
7 1200 679 1879 171 97 239 99
8 1200 768 1968 150 96 246 89
9 1200 873 2073 133 97 230 105
Output TFC TVC TC AFC AVC ATC MC
(units) (TFC/Q) (TVC/Q) (TC/Q)
(1) (2) (3) (4) (5) (6) (7) (8)
0 100 0 100 -- -- -- --
1 100 25 125 100 25 125 25 (125-100)

2 100 40 140 50 20 70 15(140-125)

3 100 50 150 33.3 16.6 50 10 (150-140)

4 100 60 160 25 15 40 10(160-150)

5 100 80 180 20 16 36 22(180-160)

6 100 110 210 16.3 18.3 35 30(210-180)

7 100 150 250 14.2 21.4 35.7 40(250-210)

8 100 300 400 12.5 37.5 50 150(400-250)

9 100 500 600 11.1 55.6 66.7 200(600-400)

Relationship between Marginal Cost and Average Cost

• 1. When Average Cost is minimum, Marginal

cost is equal to Average Cost.
• MC curve intersects at the minimum point of
ATC curve.
• 2. When MC curve is below AC curve, marginal
cost is less than average cost, and the latter falls.
• 3.When the MC curve is above AC curve,
marginal cost is more than average cost, the latter
rises.
MARGINAL COST AND AVERAGE COST LINES

MC AC
COST

A M P
B
NN
C

O L Q

OUTPUT
 Esimation of Cost Functions
Relationship between cost and output is
expressed by cost function.

TC = f(Q)
TC = Total Cost Q = Quantity of output
 Three variants of Short-run Cost function
1.Linear Cost function
1. Linear function: TC = a + bQ
(TFC + TVC) (TFC) (AVCxQ)
TVC
ATC = TC/Q = TFC/Q + TVC/Q = a/Q + b
TC=a + bQ
MC = C = b
Q

cost
Illustration:
TFC
TC = 100 + 0.5Q (Q=10)
FC = 100 ; TVC = 0.5Q output
At Q = 10, TVC = 0.5 x 10 = 5 and TC = 100 + 5 = 105
ATC = a/Q + b = 100/10 + 0.5 = 10.5
C =b
 Explanation of Linear Cost function
The firm has fixed costs which must be met irrespective of the quantity of
output produced. This is represented by a in the equation TC=a+bQ
The firm must pay proportional amount for rawmaterials, labour and other
inputs, which is the TVC represented by bQ in the equation.
The equation for Total Cost = Total Fixed Cost + Total Variable Cost
Will thus be given as TC = a + bQ.
At Zero output TC = a + bxo = a =TFC
Average Total Cost = TC  Output Q = a/Q + b
Average Fixed Cost = a/Q and Average variable cost = b
Since in the shortrun, TFC is the same irrespective of output, all increases
(differentials) in cost due to increase (differentials) in output will be
the Marginal Cost MC = b
 Quadratic Cost Function
TC=a + bQ + cQ2
TC = a + bQ + cQ2

cost
ATC = a/Q + b + cQ TFC

MC = b + 2cQ
Here, the firm has Fixed Costs Rs.5000 and output
Variable costs for (labour, raw materials etc.) to produce Q units are 250Q + 3Q2
Firm’s initial cost of producing Q units is 250Q
Additional units can be produced at increased cost due to shortage of raw materials
and other inputs (their price being higher) ups their price by +3Q2 which is the last
variable.
 Implications of the Quadratic equation:
a + bQ + cQ2
• 1. If Q = 0, TC = a = TFC
• 2. Number of bends in the Graph is 1,
• Number of bends = 1 less than highest
exponent.(Q2) .
• ATC = TC/Q = a/Q + b + cQ
• AFC = a/Q, therefore, AVC = b + cQ
• MC = b + 2cQ (by differentiation)
• When Q = 0 MC = AVC = b
There can be another type of Quadratic
Equation TC = a + bQ – cQ2
Here – cQ2 represents reduction in costs on
account of increased productivity. The TC
curve will rise at a decreasing rate.
TC = a + bQ -- cQ2
cost

TFC

output
Problem:
ABC Ltd.estimates its total cost Rs.Y of manufacturing X units of
electronic gauges per month as Y = 8000 + 300X + 0.1X2

(i) Calculate the average cost of producing 200 gauges per month.

(ii) If the company doubles this output, will it halve its average cost?
(iii)If not, what will be its average cost be?

(iv) How much is the average variable cost of producing 200 units
per month?
(v)What will be the average variable cost if no units are
Produced?

(vi) What will be the marginal cost function of the company?

 Cubic Cost Functions
• Cubic type of function will be
• TC = a + bQ + cQ2 + dQ3
• Here the highest exponent is 3. Hence one less than 3 bends will be
thre in the cost curve.
• This function combines both increasing and decreasing productivity or
returns. TC=a + bQ = cQ2 +dQ3
Increasing Decreasing
Productivity Productivity
cost

TFC

output
(i)Total cost of producing 200 gauges (iv) Average cost of producing 400 units
Y = 8000 + 300X + 0.1X2 Y = 8000 + 300 + 0.1(400)
= 8000 + 300(200) + 0.1(200)2 X 400
= 8000 + 60000 + 0.1(40000) = 20 + 300 + 40
= 8000 + 60000 + 4000
= 360 Rs.360
= 72000 Rs.72000
The average cost has not been halved.
(ii) Doubling the output, X = 400
The reduction in fixed cost has been
Y = 8000 + 300X + 0.1X2 offset by increase in AVC.
= 8000 + 300(400) + 0.1(400)2
(v)Average variable cost of producing
= 8000 + 120000 + 0.1(160000) 200 units per mointh is
= 8000 + 120000 + 16000
AVC = b + cX
= 144000 Rs.1,44,000.
= 300 + 0.1(200)
(iii)Average cost of producing 200 units
Y = 8000 + 300 + 0.1(200) = 300 + 20 = Rs.320
X 200 If no units are produced, X really does
= 40 + 300 + 20 not exist. So no question of AC.
= 360. Rs.360 (vi)MC = 300 + 0.2X